People walk past stores on Yonge street in Toronto, in May, 2023.Ammar Bowaihl/the Globe and Mail
Daryl Ching is the founder and owner of Vistance Capital Advisory, which provides accounting, capital raising and financial management services to small and medium-sized companies.
Small businesses have traditionally had two ways to raise capital: debt or equity financing. What happens to small businesses if one of these options no longer becomes available? This is the situation we see now.
After a fairly stable interest rate environment following the 2008-09 financial crisis, rates have climbed dramatically in a short time frame – resembling a hockey stick graph. As of March, 2020, the Bank of Canada policy rate was steady at 1.75 per cent. But as we entered an inflationary environment, the rate increased to 5 per cent by July, 2023. Correspondingly, small business loans for companies in good standing have increased sharply from 6 or 7 per cent to more than 9.5 per cent.
This effectively priced a lot of small businesses out of the market, as they could not demonstrate the ability to service higher interest payments. Alternative sources of debt financing, such as federal Scientific Research and Experimental Development tax incentives, purchase orders and loans from subordinate debt providers who often lend at rates north of 18 per cent, can be even harder to service. As a result, many small businesses that require financing have been forced into the equity market.
Business owners who never considered it before are now opting to sell shares of their business for growth capital – and, in some circumstances, to pay down their high-interest debt.
Raising equity certainly has its merits and has led to great success for many businesses. It’s an opportunity to bring on a strategic partner that can support your business’s operations. There are no interest payments tied to the capital, which helps cash flow. And the partnership can work out if interests are fully aligned. However, raising equity is not the ideal strategy for everybody.
Early-stage equity investors have a different profile from a lender. They seek much more upside and therefore push companies to riskier business models that can result in a higher valuation when those investors exit. For high-growth businesses that aim for a high return and a short-term investor exit, an equity raise is a great strategy. However, for more conservative businesses that have a lower risk and reward profile, or for business owners who want steady organic growth, equity is not an attractive option.
A full equity raise is time consuming when compared to applying for a loan with a bank that is already familiar with your business. It can take up to a full year. Business owners shift their attention to constantly amending investor presentations, three- to five-year financial forecasts and meeting with investors. This takes their attention away from focusing on their core business – to the point where revenues drop significantly through this process.
There’s also no certainty at the end of that process. Small businesses get locked up in long due diligence sessions, only to have deals fall apart at the 11th hour for various reasons, and that has resulted in bankruptcies in some cases in which indebted companies spend all their effort and resources on an equity raise.
Even with successful equity capital raises, entrepreneurs may end up handing over control of the company, especially now, when they are unlikely to get favourable terms due to their lack of options. If investor interests are misaligned, companies spend their energy infighting and often end up in litigation.
As of July, 2024, the Bank of Canada has cut interest rates twice recently. While that is a great sign and a step in the right direction, a 0.5 percentage point reduction is not going to have a significant impact on business financing in the grand scheme of things.
If small business loan rates can return to the 6 to 7 per cent range we saw before COVID-19, it would open the door for small businesses looking to grow to seek debt financing as a viable alternative. Considering the general lack of funding available for entrepreneurs in Canada compared with the United States, we need a healthy debt market for companies to thrive. The Bank of Canada needs to continue to lower interest rates back to pre-COVID levels for the small business environment to be competitive again.